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The Equation of Change - Essay Example

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The “equation of exchange” is a fundamental equation in economics that demonstrates the relationships among money supply, the level of price, velocity of money and the index of spending. MV = PQ. MV represents the expenditure (the money supply (M) times the velocity of money (V)…
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The Equation of Change

Download file to see previous pages... This can also be considered as the number of times that the currency is spent on finished products and services per year. PQ is the nominal GDP of the country (the level of price (P) times the physical amount of products and services (Q). Economists believe that changes in the supply of money especially improper monetary policy are the most significant factors that cause macroeconomic stability.
Importance of the stability or lack thereof, of the velocity of money directly relates to the control of the money supply (Thomas, 2005). If the velocity was always constant, then the money supply would be the single determinant of the level of national GDP spending. No policy instrument other than the central bank’s control would be needed to accurately control GDP spending. If the velocity fluctuates in a completely unpredictable manner, then Fed Reserve-engineering changes in M would have no predictable consequence on GDP spending. The control of the money supply would be a totally ineffective method of influencing GDP. To the degree that velocity is random the influence of FED reserve money supply control on GDP spending and general economic activity is compromised. If the velocity is random but is independent of the money supply and is relatively stable and subject to acceptable good prediction, then FED policy of controlling the money supply is greatly effective way of influencing GDP spending. Question two The structure of the Federal Reserve System Federal Reserve Banks: There are twelve Federal Reserve Banks from the Federal Reserve Districts. Each bank is a legally separate corporation owned by the commercial banks in its districts. The directors of individual banks recommend the allocation of discount rate which is then endorsed by the Board of Directors. These directors also select one banker from each district to serve the Federal Advisory Council. Other functions include clearing checks, help regulating banks, withdrawing damaged currency from circulation and replacing it with new ones as well as acting between local business communities. Member Banks: These are commercial banks that hold stock in the Federal Reserve Banks; commercial banks chartered by the Federal Government; and state banks chartered by state governments. Their major function is to hold reserves as deposits or vault cash at the Federal Reserve Banks. Board of Governors: consist of seven members appointed by the president and led by the chairman. All governors must come from different states and are voting members of the FOMC. They set reserve requirements, set bank regulations and select recommendations to set the discount rate. The board has authority over certain regulations unrelated to fiscal policy but have significant impacts on the monetary system. Federal Open Market Committee: The committee consists of the members of the Board of Governors, president of the New York Fed, and presidents from four other Reserve Banks. The major function of FOMC is to make decisions concerning the conduct of open market operations and hence controls the monetary base. The committee has the key responsibility of formulating monetary policy. Federal Advisory Council: comprises of the twelve representatives of the banking system. The council advices and consults with the Board of Governors on all issues within the board control. The Reserve Banks selects one representative from the district who normally serves for a term of three ...Download file to see next pagesRead More
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